What is a merger arbitrage strategy?
Merger arbitrage is an investment strategy that can be used by alternative mutual funds.
You have probably heard of “merger and acquisition” or “M&A” events: these occur when one company acquires another. Merger arbitrage strategies, accordingly, attempt to profit by speculating on whether these M&A deals, once announced, will in fact be successfully completed.
Typically, when a target company is made a takeover offer by an acquiring company, the offer price does not fully converge with the target company’s stock price. This difference reflects the probability that the merger or acquisition might not end up closing.
If the acquirer offers to purchase the target company with cash, a portfolio manager can buy the target’s stock, and will make a profit if it becomes increasingly likely that the deal will close, and the target company’s stock rises accordingly.
If the acquirer offers to purchase the target with its own shares, the portfolio manager can buy the target’s stock and short-sell the acquirer’s stock. This creates an exposure to the spread between the stocks, and will make a profit if the deal closes and the spread narrows.
Investors should note that merger arbitrage funds depend heavily on having plenty of M&A events to invest in, and the number of these events at any given point in time can vary significantly. In addition, investors should be aware that the risk/return profile of a merger arbitrage strategy is relatively asymmetric: that is, there is typically a larger downside in the case of a deal’s failure than the upside offered when a deal succeeds.
Looking to add alternative strategies to your portfolio?
Consider the following funds: